OPEC

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For years it was fashionable to use the Organization of Petroleum Exporting Countries (OPEC) as an example of a successful cartel. OPEC greatly raised the price consumers pay for oil products, made a fantastic amount of money, and has survived for years. Today, however, its returns are much smaller than in its heyday. It is not clear that OPEC was or is a profit-maximizing cartel.

Table 1 presents a chronology of major events in the history of OPEC, which was formed by five major oil exporters in September 1960. Some economists believe that prior to the formation of OPEC and for several years thereafter, the seven major oil companies (the Seven Sisters) kept the price of oil above the competitive level by restricting output. According to these economists, the price of oil declined throughout the 1960s and early 1970s because the entry of independent oil companies increased the competitiveness of the market.

From 1970 to 1973 exporting countries increased their control over supply (through agreements and nationalizing production). As a result, their revenues from crude oil became more linked to the actual market price for refined oil. In October 1973, six Persian Gulf members of OPEC met and raised the amount they charged the oil companies. Also in October, in response to the fourth Arab-Israeli war, the Arab governments ordered oil production cutbacks and placed an embargo on oil shipments to the United States and the Netherlands. The price of oil shot up: the 1974 real price was triple that of the year before, as shown in Figure 5.1. The price held steady or slightly declined in real terms for the next several years. Then, in 1979-80, it again increased substantially, to more than five times the price in 1973. Since then, the price has declined in real terms. By 1986, the real price of gasoline was only 10 percent above the 1964 level. The real price has remained relatively constant since then.

After OPEC's first large price increase at the end of 1973, many economists, political scientists, journalists, and other self-proclaimed seers turned out article after article on OPEC. Each explained why OPEC was or was not a cartel, why it was or was not about to self-destruct, why or why not oil prices would continue to rise, and why or why not the earth was going to come to an end because of the increase in the oil price. Unfortunately, this plentiful supply of articles abated at about the time OPEC had existed for long enough to provide sufficient data to test the various theories.

This appendix will not end the delightful activity of speculating about the nature of OPEC by providing a definitive statement; rather, it summarizes four of the major theories put forth by economists and others in light of the available evidence.

OPEC is a profit-maximizing cartel. The cartel agreement may break apart from time to time (countries produce too much output), but OPEC generally is able to meet and reestablish the cartel. A slight variant of this theory holds that OPEC countries have different discount rates and hence disagree on setting a price to maximize the present discounted value of profits.

Saudi Arabia is a dominant firm. Saudi Arabia by itself (or possibly in conjunction with a small core group within OPEC) acts as a dominant firm by restricting its own output. As the world's biggest producer, Saudi Arabia does not have to rely on the other more volatile countries within OPEC.

OPEC is trying to achieve political objectives rather than maximize its profits. In one version of this theory, Arab members of OPEC are using oil as a weapon against Israel and the West. In another, oil money is used primarily for domestic investments by OPEC nations, so these countries try to raise only the money they need for these investments.

The oil industry is competitive: OPEC is little more than a social club. This theory holds that the oil industry is so competitive that OPEC has no monopoly power. The reason price increased so substantially in 1973 was that the competitive supply curve is backward bending, so that a slight shift in supply or demand can dramatically increase price and reduce output.

These theories are not necessarily inconsistent with each other. For example, OPEC's political and economic objectives might coincide. A fifth hypothesis holds that a number of unusual, random events are responsible for the price rises associated with OPEC. As this sort of atheoretical approach is hard to prove or disprove, it is ignored here.

The chronology, Table 1, of major OPEC events and statements by OPEC leaders does not resolve the question as to which of the four theories is correct. After all, public explanations given by OPEC leaders as to the reasons for their activities may bear little resemblance to their true motives.

The Monopoly-Cartel Theory

Besides the two large price increases that occurred in the 1970s, other evidence supports the monopoly-cartel theory. For example, a large share of the market is a necessary condition for a cartel to exercise monopoly power. The first column of Table 2 shows that in the 1970s OPEC sold two-thirds of total noncommunist oil production. In 1981 and 1982, however, OPEC's share of world output fell significantly, in part because it was operating at less than its full capacity. Whether this drop was due to competition from other producers, wars in the Middle East (reduced production in Iran and Iraq), or other factors is not clear, but it might indicate the end of any substantial monopoly power.

Because oil is a nonrenewable natural resource, the price of oil is expected to rise over time (as the supply runs out) regardless of the market structure. Some models of a nonrenewable resource show that a monopoly sets a higher initial price than does a competitive industry. Due to its relatively high price in early years, the monopoly sells oil slowly, so the resource is exhausted less rapidly than under competition. In both monopoly and competition, the interest rate influences price; thus, a small change in the interest rate could have a substantial effect on the path that prices would follow.

Pindyck (1978) contrasts a model in which OPEC behaves as a monopoly to one in which it behaves competitively. Pindyck modifies the standard monopoly model to take account of the slow rate at which consumers adjust to a rapid increase in price. For example, in the long run, consumers may buy smaller cars and put more insulation in their homes, allowing them to reduce their demand for oil; in the short run, they are not able to make such adjustments (that is, long-run demand elasticities are greater than short-run elasticities). In Pindyck's monopoly model, OPEC's profit-maximizing strategy was to charge a high price initially (taking advantage of the slow rate of adjustment of net demand to higher prices), then to lower price through the 1970s, and then to raise it as the oil reserves were depleted.

As Table 2 shows, oil prices increased substantially (197374), were roughly constant in real terms for a few years (197578), shot up again (197980), and then fell (198182). Apparently Pindyck's profit-maximizing strategy does not describe OPEC's plan.

The first two columns of Table 3 show Pindyck's simulations of OPEC's output under monopolistic and competitive behavior respectively (assuming a discount rate of 5 percent). For the period shown, the competitive output is always greater than the monopoly output, while from 1976 to 1980 OPEC's actual ouput (column 6) lay between the simulated monopoly and competitive outputs. In 1981 and 1982 OPEC's actual output was very lowprobably lower than the profit-maximizing monopoly level.

It seems reasonable to expect that if market power is being exercised, either OPEC as a whole or some substantial subset is restricting output to drive up price. As shown in Tables 2 and 3, OPEC's output and capacity utilization levels were high in the first few years following the substantial 197374 price increases. These levels did not fall until 197980, when the second large price increase occurred. Both output and capacity levels have been falling since then (possibly for noneconomic reasons, such as wars).

How could OPEC have raised prices in the early 1970s and still have increased output? Apparently, the coordinated OPEC boycott of the United States and other Western nations in 1973 caused many to panic, and several countries built up large stockpiles for protection against future disruptions in the supply of OPEC oil. Stockpiling kept demand high for several years. Substitution away from oil by firms and households, worldwide recessions, and an end to the policy of stockpiling has reduced the demand for oil in recent years. As a result, OPEC has reduced output each year since 1980, and it lowered its price in 1982.

This analysis suggests that OPEC's output has generally differed from the monopoly level. As Table 1 shows, many debates have occurred within OPEC's ranks as to how to set price and output levels. Even if one believes that OPEC is a unified cartel some of the time, one must concede that its cartel agreement breaks apart often. Rather than viewing OPEC as a unified cartel, many economists use a dominant-firm model to describe its behavior.

The Cartel Core-Dominant Firm Model

Many people argue that Saudi Arabia acts as a dominant firm while many other OPEC countries are price takers. One problem with claiming that Saudi Arabia is a dominant firm is that its share of OPEC production rose from 23.98 percent in 1973 to 36.8 percent in 1980. Some of the increase in Saudi Arabia's share, however, may have been due to reduced output by warring OPEC nations.

A more sophisticated model holds that Saudi Arabia and a few other OPEC nations collectively act like a dominant firm and restrict output. While several OPEC countries have had substantial excess capacity in various years (see Table 2), it is generally believed that non-OPEC producers have had little excess capacity since 1973 (Griffin and Teece 1982, 29). For example, Adelman (1982) contends that a cartel core within OPEC (Saudi Arabia, the United Arab Emirates [UAE], Kuwait, Qatar, and Libya) has acted as a profit-maximizing dominant firm, facing a competitive fringe composed of non-OPEC producers. Saudi Arabia has not reduced its output to the short-run profit-maximizing level because it fears that high prices speed the development of viable oil substitutes or induce consumers to make investments that allow them to purchase less oil, increasing the elasticity of demand for OPEC oil in the future. [Adelman notes that the Saudis, despite talk of lowering prices for political or other reasons, have raised their prices overall.]

Adelman argues that when oil prices are high, the cartel partially breaks down: Countries start to produce more and undersell each other. The resulting fall in the price of oil induces Saudi Arabia (and, in some cases, other countries) to cut back production. As shown in Table 2, Saudi Arabia's output and market share fell in years when the real price of oil fell and rose in years when the real price increased.

Adelman implicitly divided demand for OPEC oil into two groups: oil for short-term use and oil for stockpiles (to ease the shock of future embargoes or other cutbacks). When Saudi Arabia cuts back production, importers' uncertainty increases their demand for stockpiles, so the total demand for oil increases. Thus, supply cutbacks cause short-term buyer panics, enabling OPEC to raise its prices without losing its share of the market. Each time, as uncertainty diminishes and prices peak, OPEC countries again increase production and undersell each other, starting the cycle over again.

In another variant of the dominant-firm model, Hnyilicza and Pindyck (1976) suggest that some OPEC nations have lower discount rates (interest rates) than others. One group of "saver" countries (Saudi Arabia, Libya, Iraq, Abu Dhabi, Kuwait, and Qatar) has relatively large oil reserves and little immediate need for cash, and thus uses a low discount rate in computing the present value of profits. The "spender" countries (Iran, Venezuela, Indonesia, Algeria, Nigeria, and Ecuador) have relatively small reserves and immediate cash needs, and so use a higher discount rate. The spender group wants high profits today, whereas the saver group wants high profits in the long run.

According to Hnyilicza and Pindyck, most of the debate among OPEC nations is about market shares. Table 3 presents the simulation results for their model, assuming that the market share of the two groups of nations is fixed at the 1974 level. According to the simulations, saver countries initially cut back output more than spender countries (total output falls and then rises as in Pindyck's monopoly model). Although saver countries may have reduced output more initially, as Table 3 shows, the output of saver countries has been a larger percentage of the 1975 level in each successive year than has the output of the spender countries.

The Non-Profit-Maximizing Model

Many writers (including several economists) do not accept these monopoly and dominant-firm models, arguing instead that OPEC countries are not profit maximizers. For example, Teece (1982) argues that OPEC members make production decisions based on their national budget requirements, which are a function of their absorptive capacities (Rosenstein-Rodan 1961)the ability to use oil revenues (profits) and capital productively. Absorptive capacity is limited where the size of the economy is small relative to oil revenues or where a country's infrastructure (capital investments) cannot support more rapid economic development.

Teece cites cases in which OPEC countries choose less profitable domestic investment over more profitable foreign investment. As Teece notes, however, if these OPEC countries believe foreign investments are relatively risky, these domestic investments may be consistent with expected profit-maximizing behavior. Even countries that did invest in the West, such as Saudi Arabia, reported that they felt compelled to keep prices low for political reasons. Teece cites Saudi Arabia's oil minister Sheik Yamani's explanations for pursuing a moderate path: "The Kingdom is very anxious to prevent any deterioration of the world economy because that would hurt us financially in view of the large investments we have in the Western countries. To increase oil price now would also expose us to certain political repercussions because we are bound to the West by clearly defined political interests."

In Teece's target-revenue model, oil prices can rise above the competitive price path even if OPEC members do not collude: "The world price was elevated above competitive levels by good luck and special circumstances" (p. 86). If a political action, such as the 1973-74 embargo, brings oil production into the target-revenue range, individual members have no reason to cheat on the cartel and expand output. If demand curves shift down or OPEC countries' revenue needs increase, then OPEC members expand production to generate additional revenues.

Teece observes that OPEC countries set different official prices, which appears inconsistent with a cartel model. The Saudis usually sell their oil for less than other OPEC countries, which Teece argues is for political rather than economic reasons.

Adelman (1982) rejects this model because it does not explain how revenue needs change in the long run. He argues that OPEC wants to generate as much revenue as possible; how OPEC spends the revenues is a separate issue. Moreover, he notes, OPEC appears to have failed to achieve its political objectives (with respect to Israel and the Palestinians), and its price increases have hurt nominal allies in the Third World more than the industrialized nations.

Another noncollusive explanation for the increased price is that property rights changed (Mead 1979; Griffin 1985). In the 1970s there was a transfer of ownership and control of the oil concessions from the international oil companies to producing countries. The oil companies, foreseeing their loss of control over production, were using a very high rate of time discount, whereas the countries used a much lower discount rate. The standard theoretical model of competitive oil extraction predicts that the real price of oil rises at the real discount rate; thus, at a lower discount rate, the price rises less rapidly and production falls. In the short run, however, as production falls, price can increase dramatically. Only in the long run does the price rise more slowly.

Competitive Model

A final theory holds that OPEC is an unsuccessful cartel and behaves in an essentially competitive fashion. After all, at one time or another every OPEC country has increased its output substantially. The first serious statement of this theory by economists was by Crémer and Salehi-Isfahani (1989). MacAvoy (1982) also argues that the long-run trend in oil prices can be explained by a competitive model.

Using a target-revenue model, Crémer and Salehi-Isfahani contend that the supply curve for oil is backward bending. Exporting countries try to achieve a target revenue for internal investment purposes. A target revenue is set because the countries have limited capacity to absorb investment. For a given oil price, fixing revenues determines output: There is no incentive to produce more oil. OPEC, so this theory holds, is a disorganized body that does not impose output restrictions on its members; it only asks them to behave as price-takers. Thus, it is not surprising that market shares have not remained constant over time.

Figure 5.2 Competitive Theory About OPEC

Figure 5.2, which is based on Crémer and Salehi-Isfahani's diagram, shows a backward-bending supply curve with a demand curve that intersects it three times. In their explanation, the oil industry in early 1973 was at the low-price, competitive equilibrium (p1, Q1). In two steps (October 1973 and January 1974), the six Persian Gulf OPEC members agreed to raise prices, which caused a shift to the high-price equilibrium (p3, Q3). [The equilibrium at (p2, Q2) is unstable. Were the quantity to fall slightly below Q2, the price would be above p2, but demand would be greater than supply. As a result, there would be upward pressure on the price, driving it towards p3. A similar argument holds that if the price fell below p2, it would continue to fall to p1. In contrast, the (p1, Q1) and (p3, Q3) equilibria are stable.]

These price increases were supported by short-run reductions in output, possibly due to the Middle East War of October 1973. Thereafter, competitive equilibrium could be maintained at the high price. Even though each country could produce as much output as it wanted, countries voluntarily restricted output because they did not know what to do with all the revenues (limited absorptive capacity).

In real-price terms, the OPEC price took a large jump in 1973 and remained fairly constant at the higher level afterward. The only major price increase since then, in 197879, may have been due to special events that caused Iran and other countries to restrict output further. Extending this theory, the price fall in recent years is seen as due to shifts in demand. This explanation apparently implies that demand fell for years.

Verleger's (1982) empirical study indicates that OPEC countries set their official prices in response to shifts in demand. He concludes that attempts to persuade members of OPEC to exercise price restraint have no effect. All countries adjust their official prices as the price in the competitive spot market (market for immediate delivery) changes. The so-called price moderates within OPEC are not following moderate pricing strategies at all, but only adjusting prices at a slower rate. Crémer and Salehi-Isfahani (1991) point to unpublished empirical work by Salehi-Isfahani that supports their view.

Conclusions

OPEC has a large share of the market and entry by competitors is slow. Moreover, in some periods, price has increased substantially. These factors support a monopoly or dominant-firm model. On the other hand, the cartel agreement appears to break down regularly, resulting in prices below the profit-maximizing level. Some countries probably vary their production for political rather than economic reasons. Alternatively, OPEC countries may have limited capacities to absorb revenues in making only domestic investments. Taking the argument for limited absorptive capacity to its limit, it is even possible that the price increase reflects a shift to a high-price, competitive equilibrium. There is relatively little support, however, for this last view.

Although currently available empirical studies do not clearly confirm or reject any of the four hypotheses about OPEC's behavior, stronger conclusions may be reached in the near future. Since the peak in real prices in 198081, OPEC's real price has fallen substantially. Presumably this price drop reflects the destruction of a cartel, but more study is required to draw definitive conclusions.

SOURCES:

Adelman, Morris A. 1982. "OPEC as a Cartel," in James M. Griffin and David J. Teece, eds., OPEC Behavior and World Oil Prices. London: George Allen & Unwin.